Chapter A: Personal taxation

A2. Retirement incomes

A2–2 Taxing retirement incomes

Superannuation is the main form of lifetime saving outside the family home. There is a bias in the current taxation system against long-term saving, particularly lifetime saving such as superannuation. There are at least two reasons for taxing superannuation more favourably than other saving (with the exception of housing) to reduce this bias.

The first reason is that taxing superannuation earnings, like the earnings on most forms of savings, means that the effective rate of tax on the real value of saving increases the longer an asset is held (see Section A1 Personal income tax). This effect is more pronounced in superannuation than other savings as superannuation saving is generally held for a longer time. This justifies a more favourable tax treatment.

The second reason is that superannuation is a form of deferred income. People should be taxed on superannuation at the rate that would apply if their income had been spread over their entire life rather than merely over their working life. This is an income-smoothing argument. As a person's retirement income is generally lower than their income while they were working it should be taxed at a lower rate.

Many OECD countries deal with the effects of inflation and income-smoothing by taxing retirement benefits at a person's marginal tax rate, and exempting contributions and earnings from income tax. This is an example of an expenditure tax treatment of savings (see Box A2–1). The Australian approach is, instead, to achieve an approximation to the expenditure tax treatment by embedding superannuation concessions in an income tax framework.

Box A2–1: Tax benchmarks for retirement savings

The return to savings is made up of a number of components including compensation for deferring consumption (the 'risk-free' or normal return), a return to risk-taking and economic rent (see for example, US President's Tax Reform Panel 2005).

Most countries' retirement income systems use an expenditure tax benchmark. There are two types of expenditure tax benchmarks: pre-paid and post-paid.

A pre-paid expenditure tax is based on direct taxation of labour income with an exemption for income from saving. That is, all components of the return to savings are exempt from tax. Under the pre-paid expenditure tax benchmark, superannuation contributions are taxed at an individual's personal tax rate with both earnings and benefits tax-exempt.

A post-paid expenditure tax is based on the taxation of a direct measure of expenditure or of goods and services. This differs from a comprehensive income tax in that it exempts the normal return to saving. The return to risk-taking and any additional returns are treated similarly under both an income tax and a post-paid expenditure tax. Under the post-paid expenditure tax, both contributions and earnings would be tax-exempt but benefits would be fully taxable when paid.

In Australia, both contributions and earnings are included as income in the superannuation fund and taxed, generally at 15 per cent, while superannuation benefits are tax-exempt when paid after the age of 60. The terms of reference of this Review preclude it from considering the tax-free status of superannuation payments for the over-60s.

It is possible, however, to achieve a system that provides a similar tax outcome as other OECD countries. This system would tax contributions at a rate lower than the marginal tax rate on employment income and have earnings and benefits largely tax-free. As savings are taxed only once — on contributions — this is another type of expenditure tax of retirement savings. The Review's recommendations in this section — to tax contributions at marginal tax rates with a capped offset, and with a very low tax rate on earnings — combine to achieve this outcome.

In considering the equity of the superannuation tax concessions, the Review has had regard to whether people on different incomes are treated consistently and whether people can readily take advantage of the tax preferences. Rules that restrict access to concessions based on a person's employment arrangements, such as whether their employer allows salary sacrifice contributions, mean that people in similar circumstances can receive different outcomes.

Principles

Superannuation's sole purpose is to provide a lifetime savings vehicle, and savings should be invested to maximise returns without being subject to competing policies that would require, for example, specific asset allocation. Given this lifetime savings purpose, superannuation should receive preferential income tax treatment compared to other savings. As the Review's terms of reference rule out taxing superannuation benefits, the key taxing point must continue to be superannuation contributions.

The objectives for the taxation of superannuation savings should be to:

provide an equitable distribution of concessions for people with different incomes, consistent with the degree of progressivity in the personal income tax rates scale;

encourage saving for retirement;

make it simpler for people to get access to concessions; and

ensure the sustainability of the retirement income system into the future.

The equity, complexity and adequacy impacts of the current tax arrangements

A flat rate of tax (15 per cent) generally applies to the income of a superannuation fund, which includes contributions and earnings during the accumulation stage.

Many submissions to the Review have stated that taxing contributions at a flat rate of 15 per cent is unfair to low-income earners. They argue that many low-income earners would pay less tax if the contributions were paid as wages. They note that low-income earners receive a significantly smaller concession than high-income earners.

Based on the 2008–09 tax rates, around 1.2 million individuals do not receive a personal income tax benefit from their concessional superannuation contributions. An additional 1.2 million people receive a concession of only 1.5 percentage points (Treasury 2008). This compares with around 200,000 taxpayers (those earning more than $180,000) who receive a concession on their superannuation contributions of 31.5 per cent.

Different types of superannuation contributions receive tax concessions in different ways. An employee effectively receives a deduction for contributions made from pre-tax income (that is, superannuation guarantee and salary sacrifice contributions). A person who is self-employed can also claim a deduction for contributions. Contributions made from post-tax income may be eligible for the government superannuation co-contribution or superannuation spouse contribution tax offset.

Providing different concessions for different types of contributions can complicate planning for retirement. For example, to get the full value of the concessions on their saving, a person who is eligible for the superannuation co-contribution may have to make a contribution from their post-tax income and a salary sacrifice contribution.

Table A2–1 shows how the type of contribution affects the concessions from a $1,000 contribution made by a person who earns $40,000 a year. Such a person is entitled to a co-contribution that matches their post-tax contribution on a dollar for dollar basis, but this is capped at $1,000. The maximum co-contribution reduces by 3.33 cents for every dollar the person earns above $31,920. Accordingly, the person's maximum co-contribution is $731. A post-tax contribution above $731 is not eligible for a co-contribution, so a person should make a salary sacrifice contribution of $269 to maximise their concessions.

Table A2–1: Value of tax concession for a $1,000 contribution

$1000
salary-sacrifice contribution

$1,000
post-tax contribution

Split contribution
($731 post-tax,
$269 salary-sacrifice)

Value of tax deduction (salary-sacrifice)

$355

Nil

$95

Value of co-contribution (post-tax contribution)

Nil

$731

$731

less: tax in fund

$150

Nil

$40

Total value of concession

$205

$731

$786

Note: The value of the deduction depends on the person's marginal tax rate (30 per cent), Low Income Tax Offset phase-out plus the 1.5 per cent Medicare levy.

Source: Treasury estimates.

Submissions also argue that the current system is unfair because it does not allow employees a deduction for personal superannuation contributions. Some employees can avoid this restriction by sacrificing part of their remuneration for additional employer contributions. However, not all employers offer salary sacrificing arrangements. This creates an inequity between people whose employer provides salary sacrifice and those whose employer does not. Aged-based restrictions also mean that people cannot make superannuation contributions from age 75.

Taxing superannuation contributions in the fund reduces the value to the employee of the 9 per cent superannuation guarantee contribution rate to 7.65 per cent. This reduces the adequacy of the superannuation guarantee system in an inequitable way.

Findings

The structure of the existing tax concessions is inequitable because high-income earners benefit much more from the superannuation tax concessions than low-income earners.

The complexity of the tax arrangements imposes an unnecessary cost on individuals in gaining access to concessions. Complexity also adds to the administration costs of superannuation funds, which affect retirement incomes.

Access to concessions should not depend on an employer's remuneration policies, such as whether a person can make salary sacrifice contributions. The age limit on who can make superannuation contributions also limits access to concessions.

Taxing superannuation contributions reduces the level of superannuation guarantee contributions invested in the fund. This limits the adequacy of the superannuation guarantee in providing for retirement incomes in a way that is inequitable for low-income earners compared with other saving alternatives.

A new arrangement for taxing superannuation contributions

Recommendation 18:

The tax on superannuation contributions in the fund should be abolished. Employer superannuation contributions should be treated as income in the hands of the individual, taxed at marginal personal income tax rates and receive a flat-rate refundable tax offset.

An offset should be provided for all superannuation contributions up to an annual cap of $25,000 (indexed). The offset should be set so the majority of taxpayers do not pay more than 15 per cent tax on their contributions. The cap should be doubled for people aged 50 or older.

An annual cap on total contributions should continue to apply.

The offset should replace the superannuation co-contribution and superannuation spouse contribution tax offset.

Compulsory superannuation contributions made by employers should not reduce eligibility for income support or family assistance payments. They should also not form part of the calculation for child support.

The taxation of superannuation contributions has a significant effect on the system's equity, simplicity and ability to encourage retirement saving. It also affects a person's retirement income and the sustainability of the superannuation tax arrangements.

The Review recommends removing the taxation of superannuation contributions within a superannuation fund and replacing it with a system that is more equitable, simple and provides higher retirement incomes.

Superannuation contributions should be taxed at a progressive but concessional rate. This would be achieved by treating employer superannuation contributions as income in the hands of the employee, taxed at marginal personal income tax rates. A flat-rate refundable tax offset, payable to the individual, would apply to these contributions to ensure that investing in superannuation retains its preferential tax treatment over other types of saving.

The offset should be available in respect of employer contributions as well as other contributions made by, or on behalf of, a person. This would provide a more consistent treatment for all contributions regardless of their source. The offset would also apply to contributions made by people who are not employees, such as the self-employed. This would replace the deductions that currently apply to these contributions.

The rate of the offset should be set so that the effective tax rate (marginal tax rate less offset) on superannuation contributions, up to a cap, remains at 15 per cent for a person on the standard marginal tax rate. The standard rate is the rate that applies to the majority of taxpayers. Under the indicative personal income tax rates scale in Section A1–1 The structure of personal income tax, this would be 35 per cent.

Taxing contributions within the superannuation fund would no longer apply. This means that the full amount of contributions (both superannuation guarantee and salary sacrifice contributions) would be invested in the fund on behalf of the person. The effect of this change, along with recommended changes to the taxation of superannuation fund earnings, would be to increase a person's superannuation assets at retirement. For example, the superannuation assets of a person on Average Weekly Ordinary Times Earnings (AWOTE)11 would increase from over $440,000 to over $570,000 after a full working life. (For more detail, see 'Effects of recommendations on retirement income' later in this section.)

Improving the distribution of concessions

The recommendation would integrate employer superannuation contributions into the personal income tax system. This, along with the flat-rate tax offset, would increase the equity of the superannuation system by increasing the progressivity of the taxation of superannuation contributions (see Chart A2–1).

Under the recommendation, a person with income below the tax-free threshold would not pay tax on their superannuation contributions. The effective tax rate on contributions would remain at 15 per cent for the majority of income earners and increase for higher-income earners. People who have income below the tax-free threshold would pay no tax on their contributions but would still be eligible for the offset, while people on the highest tax rate would pay more than 15 per cent.

Chart A2–1: Progressive taxation of superannuation contributions

Note: This chart is based on the indicative personal income tax rates scale in Section A1–1.

Source: Treasury estimates.

The recommendation provides for a similar tax result to that in OECD countries that only tax benefits at marginal tax rates (rather than contributions and earnings). In these systems, a person generally has less income in their retirement than when they were working. This means they would pay a lower average tax rate on their retirement income compared to their pre-retirement income. The offset replicates this effect by reducing the tax rate paid on superannuation contributions compared to the tax rate paid on a person's working income.

Under the recommendation, the maximum concession a person could receive on their contributions would be the value of the offset (in this example, 20 per cent). The level of concessions for low-income earners on their employer contributions would increase significantly while the concessions for high-income earners would decrease. This would target the concessions more effectively by increasing the savings of lower-income earners (see Chart A2–2).

The OECD (2007a) considers that the distribution of concessions is an important indicator of the success of concessional saving vehicles. It found that a policy is more effective if it increases the retirement savings for people on low to moderate incomes, as high-income earners are more likely to switch their savings to the preferentially taxed vehicle. Although concessions for higher-income earners would decrease under the recommendation, the offset would still provide a substantial incentive for them to make voluntary superannuation contributions.

Chart A2–2: A more equitable concession for contributions

Based on a 20 per cent offset(a)

The chart assumes a single person who does not receive income support. The figures for the current situation are based on the 2009–10 marginal tax rate schedule with Medicare levy. In this case, a person on 0.5 x average weekly ordinary time earnings (AWOTE) has a marginal tax rate of 16.5 per cent, a person on AWOTE has a marginal tax rate of 31.5 per cent and a person on 3 x AWOTE has a marginal tax rate of 46.5 per cent. AWOTE is currently around $1,200 per week ($62,400 per year). Around half of workers earn less than three-quarters of AWOTE.

Note: The recommended concessions are based on the indicative personal income tax rates scale in Section A1–1.

Source: Treasury estimates.

Simplifying the system for individuals and superannuation funds

Moving to a single offset would simplify the system for many individuals. To get the maximum tax concession out of the current superannuation arrangements, many people must enter into an arrangement with their employer to make a contribution. In some cases employees are charged a fee to have these contributions made on their behalf.

Moving to an offset for all superannuation contributions would allow a person to deal directly with their superannuation fund. This would remove the third-party arrangements with employers that currently exist in the system. It would also increase the transparency of the superannuation contribution concessions by collapsing the existing different concessions into one (see Chart A2–3). This would remove the need for individuals to seek tax planning to optimise the structure or pattern of contributions. This tax planning also increases the costs individuals can face when making a decision whether to make voluntary superannuation contributions.

Chart A2–3: A more consistent treatment of superannuation contributions

Based on the indicative personal income tax rates scale in Section A1–1.

There would also be benefits for superannuation funds. Currently, funds must know whether contributions are taxable or non-taxable as they are received. Under the recommendation, funds would treat all contributions the same, making for a simpler system to administer.

Government superannuation co-contribution and spouse offset

The government superannuation co-contribution provides an incentive for low- to middle-income earners to make additional superannuation contributions. Under the scheme, a person must make a personal contribution out of their post-tax income. The government matches this dollar-for-dollar up to a maximum of $1,000 for people on incomes up to $31,920 (indexed). The value of the co-contribution reduces, and phases-out completely once a person's income is $61,920 (indexed).

Only around 20 per cent of people who would be eligible for a co-contribution currently make the necessary contribution to a fund. Many people earning less than $31,920 may find it hard to set money aside for an additional contribution. For such people the co-contribution provides no ongoing benefit as they are unable to make a contribution every year.

The abolition of the tax on their contributions, along with the offset, would provide a more effective way to increase the retirement income of low-income earners whose main source of retirement savings is their superannuation guarantee contributions. The offset would also provide a concession for voluntary savings. Therefore, it is recommended that the co-contribution be repealed.

Taxpayers can currently also claim a tax offset if they make post-tax superannuation contributions on behalf of a low-income or non-working spouse. The maximum offset for a year of income is $540. This offset should also be abolished and be replaced by the offset applying to all contributions.

Ensuring the sustainability of the superannuation contribution tax offset

The purpose of the offset would be to provide a concession for people who want to save for their retirement. While an offset may not be as generous as the current arrangements for some taxpayers, it is still a substantial concession. The retention of a cap on concessions is therefore necessary to ensure their sustainability. The Review recommends a cap of $25,000 (indexed) be applied to the amount of contributions eligible for the offset. This is equivalent to the current cap on concessional superannuation contributions.

However, many people who have extended periods outside the workforce, such as carers and middle-aged migrants, may not have had the ability to make concessional contributions over a full working life. These people should be able to make additional concessional contributions when they have the capacity to do so. Currently, there are transitional arrangements in place that allow a person aged 50 and over to make $50,000 of concessional contributions in a year. These arrangements are due to cease from 1 July 2012 when the cap will reduce to $25,000. The Review recommends that the cap remain at double the rate of the normal cap beyond this date for people aged 50 and over (see Recommendation 18a).

A cap should also continue to apply to total superannuation contributions (currently $150,000 a year), with the existing excess contributions tax applying to contributions above the cap. People should still be able to bring forward three years of contributions into one year before the age of 65.

Arrangements should be put in place to reduce the ability of a person to arrange their affairs to receive an offset. For example, contributions up to the value of a person's taxable or earned income should be eligible for a refund. This would discourage people from entering into short-term arrangements, such as borrowing, to get the benefit of the offset rather than increase their retirement income.

Also, the amount of offset should be available only for contributions in excess of an amount withdrawn from superannuation during the year. This would limit the ability of a person to churn amounts through superannuation purely to gain the value of the offset. For example, a person aged 65 and over has unlimited tax-free access to their superannuation. It would be possible for them to withdraw an amount from their superannuation fund, re-contribute it back into superannuation, access the concession and withdraw the contribution immediately. In this case, there would have been no increase in their retirement savings but they would be eligible for the full value of the offset.

Effect of recommendation on income

Under the recommendation, employers would withhold the amount of tax owing on the contribution from the employee's salary or wages, thereby reducing their disposable income. The offset would, however, act to reduce the impact on disposable income.

The effect would be to move the taxation of contributions from the superannuation fund to the individual. Taken in isolation from other changes to personal income tax, this would decrease their disposable income. It would, however, increase their retirement income, as the fund would no longer pay tax on their contributions. In this respect, the proposal is similar to requiring employees to make an additional compulsory contribution into superannuation.

Transitional arrangements

Some people would be able to reduce the effect of the proposal on their take-home pay by reducing their voluntary saving. For example, as the effect of the recommendations would be similar to an additional compulsory contribution, people who currently voluntarily contribute more than 9 per cent of their salary into superannuation could reduce this amount. In some cases, the reduction in contributions would offset the reduction in take-home pay without reducing their overall investment in superannuation.

Arrangements could also be put in place to reduce the immediate impact of the changes on disposable income. For example, the changes could be implemented as part of the broader plan to reform the personal tax system. Another option would be to start with a higher offset that would gradually phase down to the ongoing offset rate over a transition period. This rate could be set so there is no effect on disposable income for a person on the 35 per cent tax rate in the first year. Reducing the offset would transfer most of the effect on income through a reduction in real take-home pay increases. This would be similar to the effect on pay resulting from an increase in the superannuation guarantee rate. The amount of tax payable on contributions could also be phased down over the same period.

Effect on government payments and child support

Eligibility for government payments such as Family Tax Benefit and Newstart Allowance should not be affected by the recommendations. Eligibility for these payments should be based on a person's ability to meet day-to-day expenses from their accessible income and assets. As the superannuation guarantee contributions must be paid into a superannuation fund, they cannot generally be used to support a person with their day-to-day living expenses until they retire. Recommendation 18d proposes that arrangements be put in place to ensure compulsory superannuation contributions do not affect eligibility for government payments. For the same reasons, compulsory superannuation contributions should not be included when determining an individual's child support obligations.

The taxation of earnings

Recommendation 19

The rate of tax on superannuation fund earnings should be halved to 7.5 per cent. Superannuation funds should retain their access to imputation credits. The 7.5 per cent tax should also apply to capital gains (without a discount) and the earnings from assets supporting superannuation income streams.

Currently superannuation earnings are taxed at 15 per cent while they accumulate in the fund, with certain capital gains taxed at 10 per cent. If benefits are paid as an income stream, such as a pension or annuity, the earnings on the assets supporting the income stream are not subject to tax.

Because superannuation is a lifetime savings vehicle, the compounding effect of interest has a significant influence on how much superannuation a person can accumulate. The taxation of earnings reduces this compounding effect. It is therefore appropriate that earnings are taxed at a low rate. For the sake of simplicity this should be at a low flat rate within the fund without reference to the marginal tax rate of fund members.

Consistent with this, the tax rate on earnings should be halved to 7.5 per cent. This would mean that the tax paid on the earnings of an average superannuation fund would be close to zero after allowing for the effect of imputation credits. This rate should also apply to capital gains (without a discount) and to earnings supporting income streams. In the event that dividend imputation is abolished in the future, the earnings tax on superannuation should be reduced to zero. The higher tax rates on earnings that act as an integrity measure to stop people streaming earnings from related parties into superannuation should remain.

Now that superannuation pay-outs are tax-free, there is no clear rationale for retaining an exemption for earnings on superannuation income streams. The exemption was necessary while superannuation pay-outs were taxable so that a person did not pay tax on the earnings in the fund and again when they took them as income. Having a consistent tax rate on all earnings would also make the superannuation taxation system more sustainable given the ageing of the population.

It has been argued that the earnings tax exemption encourages people to take their benefit as an income stream. Individuals are likely to make decisions on how they use their retirement savings that are in their best interest. Analysis on the draw-down of assets by Age pensioners has found that over the period 2000–01 to 2003–04, 30 per cent of Age pensioners retained 80 to 100 per cent of their assets, with 30 per cent increasing their assets. Only 1 in 13 Age Pensioners had drawn down more than half of their assets from the time of claiming the pension (Lim-Applegate et al. 2005).

This indicates that people already draw down on their assets in an orderly fashion. Therefore, a concession to encourage this behaviour would provide a subsidy for a decision they were already likely to make. Such concessions are more likely to change the vehicle people choose to draw down their assets rather than how they draw down their assets. Having a single tax rate for all fund earnings would also simplify the taxation of superannuation funds. Currently, superannuation funds must put in place arrangements that allow them to identify assets supporting the accumulation and draw-down phases of retirement saving. A single rate would remove the need for these arrangements and simplify the regulation of the draw-down phase by removing the need for rules regulating the draw-down of superannuation.

A single tax rate would also improve the equity of the system for members of different funds. Currently it is possible for members of self-managed superannuation funds to arrange their affairs so they avoid capital gains tax on their assets. This involves moving assets into the draw-down phase, where earnings including capital gains are exempt, before selling them. This tax minimisation opportunity is not available to members in larger funds as these members cannot control the timing of the disposal of assets.

Extending earnings tax to assets supporting an income stream would affect people who currently have an income stream. If the government wishes to limit the impact on people who have made decisions based on the existing rules, it should examine alternative ways to achieve this rather than grandfathering the existing rules. Previous grandfathering in the retirement income system made the taxation of superannuation very complex. An alternative to grandfathering would be to phase in this change over time to reduce the immediate effect. Another option would be to use the transfer system to compensate most people for the tax paid within the fund.

Effect of recommendations on retirement incomes

A person's wellbeing in retirement depends on several key factors that should be considered together: the rate of Age Pension, the rate of the superannuation guarantee, the taxation of retirement income, the retirement age, and the funding of health and aged care. Voluntary saving is also important for people who want to achieve an income higher than can be provided by the Age Pension and superannuation guarantee savings.

The review of adequacy presented in the Review's strategic report on retirement income (AFTS 2009) considered only the superannuation guarantee rate and the retirement age. The rate of the Age Pension was considered by Dr Harmer in his review of pensions (FaHCSIA 2009).

Since the Review's retirement income report, the value of the total Age Pension package has been increased by $32.50 a week on top of indexation (to $335.95 a week) for single pensioners and $10.15 a week for pensioner couples on top of indexation (to $506.50 a week).12 The Age Pension age is also being gradually increased to age 67.

These decisions have significantly increased potential retirement incomes beyond the levels considered by the Review in the retirement income report. For example, the replacement rate — which compares a person's spending power before and after retirement — for a person on average weekly ordinary time earnings (AWOTE) increased from 63 per cent in the retirement income report to 71 per cent after the Age Pension increase (see Chart A2–4).

Finding

The increase to the Age Pension in September 2009 and the Age Pension age have considerably increased the potential retirement incomes of Australians.

Effect of recommendations on replacement rates

The Review has reassessed the potential outcomes of the retirement income system for this Report. Building on Dr Harmer's earlier review of the effect of the increase in the Age Pension on retirement incomes, the Review has reassessed adequacy in the context of the wider recommendations on what a future tax and transfer system might look like. This has provided a more complete basis on which to estimate the potential outcomes of the retirement income system.

The recommendations to change the taxation of superannuation, in addition to the increase in the Age Pension, would increase retirement incomes significantly. For example, the replacement rate for a person on AWOTE would be 76 per cent compared to 63 per cent without the Age Pension increase and the tax reform recommendations. The comparable figures for a person earning 1.5 times AWOTE are 63 per cent and 52 per cent (see Chart A2-4).

These estimates are based on a person's superannuation guarantee savings and the amount of Age Pension for which they are eligible. Recommended changes to the funding of aged care would also improve the standard of living of people in retirement (see Section F7 Funding aged care). Although these recommendations would reduce costs in retirement they are not reflected in the following charts as they would not directly increase the amount of retirement income a person has.

Chart A2–4: Illustrative projected replacements rates
under the Age Pension and superannuation guarantee(a)

A replacement rate compares a person's spending power before and after retirement (that is, income and fringe benefits after tax is paid). For example, a replacement rate of 75 per cent would mean that a person would be able to spend in a given time period $75 in retirement for each $100 spent before retirement. The illustrative replacement rates are projected for a hypothetical single male. Pre-Budget outcomes are for a male who works for 35 years and retires in 2035. Other outcomes are for a male who works for 37 years and retires in 2047. It is assumed that they use their superannuation guarantee benefit to purchase a lifetime annuity at retirement. The spending power used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008–09 dollars. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether a person accesses their superannuation prior to Age Pension age.

Note: AWOTE is currently around $1,200 per week ($62,400 per year). Around half of workers earn less than three-quarters of AWOTE.

Source: Treasury projections.

The effect of the superannuation tax recommendations, in addition to the increase in the Age Pension, would be equivalent to a 15 per cent superannuation guarantee rate over a full working life for a person earning 0.75 x AWOTE (approximately median earnings) and AWOTE before the 2009–10 Budget. However, an increase in the superannuation guarantee rate to 15 per cent under the existing tax rules would retain the existing inequitable distribution of concessions.

There are a number of views within the community on the adequacy of the retirement income system. There are different ways to increase the adequacy of the retirement income system. This report recommends changing tax arrangements, which would increase retirement incomes (as well as improving equity and simplicity of the system). Increasing the rate of the superannuation guarantee would also increase retirement incomes, (but would not, of itself, improve equity and simplicity).

The retirement income report recommended that the superannuation guarantee rate remain at 9 per cent. In coming to this recommendation the Review took into the account the effect that the superannuation guarantee has on the pre-retirement income of low-income earners. Although employers are required to make superannuation guarantee contributions, employees bear the cost of these contributions through lower wage growth. This means the increase in the employee's retirement income is achieved by reducing their standard of living before retirement.

The effect of this reduction in a person's standard of living before retirement is likely to fall most heavily on low- to middle- income earners who are unlikely to be in a position to offset the increase in the superannuation guarantee by reducing their other savings. However, it has been argued that the benefits from improving a person's standard of living in retirement offset the effect of the decrease in their standard of living before retirement.

It has also been argued that people will have different circumstances, such as the age they choose to retire and whether they retire as part of a couple, which can affect their retirement incomes. Chart A2–5 shows the replacement rates for a person who retires at age 60 under the superannuation tax proposals.

Chart A2–5: Illustrative projected replacements rates
under the Age Pension and superannuation guarantee for a person retiring at age 60(a)

A replacement rate compares a person's spending power before and after retirement (that is, income and fringe benefits after tax is paid). For example, a replacement rate of 75 per cent would mean that a person would be able to spend in a given time period $75 in retirement for each $100 spent before retirement. The illustrative replacement rates are projected for a hypothetical single male. Actual outcomes will vary depending on factors such as labour income patterns, investment performance, inflation, longevity and whether a person accesses their superannuation prior to Age Pension age.

The Post-AFTS case is for a male who works for 37 years and retires in 2047. It is assumed that they use their superannuation guarantee benefit to purchase a lifetime annuity at retirement. The spending power used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008–09 dollars. Replacement rates are calculated compared to their spending power in their final year of working.

In this case the person retires at age 60 after 30 years of work and receives Newstart Allowance until Age Pension age. They withdraw their superannuation as a series of lump sums between the ages of 60 and 67 to achieve a 50 per cent replacement of their net income at age 60 until they are eligible for the Age Pension. It is assumed that their asset is not included in the means test until they reach age 67. At age 67 they purchase a lifetime annuity with their remaining superannuation. Replacement rates are calculated compared to their spending power in their final year of working.

In this case the person retires at age 60, after 30 years of work, due to disability and is paid Disability Support Pension until Age Pension age. They withdraw their superannuation as a series of lump sums between the ages of 60 and 67 to achieve a 50 per cent replacement of their net income at age 60 until they are eligible for the Age Pension. It is assumed that their asset is not included in the means test until they reach age 67. Replacement rates are calculated compared to their spending power in their final year of working.

Note: AWOTE is currently around $1,200 per week ($62,400 per year). Around half of workers earn less than three-quarters of AWOTE.

Source: Treasury projections.

The effect of retiring before Age Pension age reduces retirement income for two reasons. The first is that a person has less time to accumulate superannuation and the second is that they must make their superannuation last for a longer period. It is projected that the retirement income system, with the tax proposals, would still provide a substantial replacement of income for people who must retire before Age Pension age. For example, an average income earner would have a replacement rate of 65 per cent if they receive Newstart Allowance and 70 per cent if they receive the Disability Support Pension.

In setting the rate for the superannuation guarantee it is appropriate to consider the average working life. For a male the full-time equivalent average working life was projected to be around 36 years (Bingham 2003). This did not take account of the effect of the recent increase in the Age Pension age. An assumption used to calculate the replacement rate in Chart A2–4 is that the person works for 37 years. Setting the superannuation guarantee rate to account for a person with a shorter working life would result in people with a longer working life saving significant amounts for their retirement. Chart A2–6 shows the replacement rates for a person who has a working life of 42 years under the superannuation tax proposals. In this case replacement rates for an average income earner increase from 76 per cent to 81 per cent.

Chart A2–6: Illustrative projected replacements rates
under the Age Pension and superannuation guarantee for a person with a working life of 42 years(a)

A replacement rate compares a person's spending power before and after retirement (that is, income and fringe benefits after tax is paid). For example, a replacement rate of 75 per cent would mean that a person would be able to spend in a given time period $75 in retirement for each $100 spent before retirement. The illustrative replacement rates are projected for a hypothetical single male. The chart shows how changing the assumption on how long a person works affects replacement rates. In both cases the person retires in 2047. It is assumed that they use their superannuation guarantee benefit to purchase a lifetime annuity at retirement. The spending power used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008–09 dollars. Actual outcomes will vary depending on factors such as labour income patterns, investment performance, inflation, longevity and whether a person accesses their superannuation prior to Age Pension age.

Note: AWOTE is currently around $1,200 per week ($62,400 per year). Around half of workers earn less than three-quarters of AWOTE.

Source: Treasury projections.

Charts A2–4, A2–5 and A2–6 only show the potential retirement incomes for a single person. However, over 70 per cent of people enter retirement as part of a couple. This affects retirement income as each person in the couple is likely to have a different life expectancy. For example, women live longer than men on average. This increases the period that retirement savings must last, thereby decreasing replacement rates. Chart A2–7 shows that replacement rates for a household are lower than for singles. A single average income earner under the tax recommendations would have a replacement rate of 76 per cent. The couple replacement rate would be 73 per cent.

Chart A2–7: Illustrative projected replacements rates
under the Age Pension and superannuation guarantee(a)

(Household)

A replacement rate compares a person's spending power before and after retirement (that is, income and fringe benefits after tax is paid). For example, a replacement rate of 75 per cent would mean that a person would be able to spend in a given time period $75 in retirement for each $100 spent before retirement.

The illustrative replacement rates are projected for a hypothetical single male who works for 37 years and retires in 2047. It is assumed that he uses his superannuation guarantee benefit to purchase a lifetime annuity at retirement. The spending power used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008–09 dollars. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether a person accesses their superannuation prior to Age Pension age.

The illustrative replacement rates are for a hypothetical couple of the same age who both retire in 2047. The male works for 37 years. It is assumed that he uses his superannuation guarantee benefit to purchase a lifetime annuity at retirement. The lifetime annuity has a reversionary payment of 85 per cent to his spouse. The female enters the workforce at age 36 and works part-time to age 44, full-time from age 45 to age 59 and part-time from age 60 to age 67. She is assumed to use her superannuation guarantee benefit to purchase a lifetime annuity at retirement without a reversionary benefit. She lives three years longer than her spouse. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, age differences between the couple, inflation, longevity and whether a person accesses their superannuation prior to Age Pension age.

Note: AWOTE is currently around $1,200 per week ($62,400 per year). Around half of workers earn less than three-quarters of AWOTE.

Source: Treasury projections.

Effect of recommendations on voluntary superannuation saving

Under the recommended changes, people would continue to have a considerable incentive to save through superannuation compared to other saving vehicles. The benefits of the recommended changes for voluntary savings are shown below.

Chart A2–8 shows illustrative replacement rates for a hypothetical person making voluntary superannuation contributions under the recommended changes. While it is difficult to determine the actual effect of the changes on voluntary saving, it is assumed that the offset, and in particular the halving of the tax on earnings, would provide significant concessions compared to other savings.

The chart uses the average rate of salary sacrifice contributions for an employee based on their age and level of remuneration. It assumes they continue to make these contributions after the changes to the taxation of superannuation and other savings. However, the maximum amount of contributions they make is capped at $25,000 below age 50 and $50,000 from age 50.

Chart A2–8: Illustrative projected replacement rates
including the Age Pension, superannuation guarantee and average salary sacrificed amounts for employees(a)

A replacement rate compares a person's spending power before and after retirement (that is, after tax is paid). For example, a replacement rate of 75 per cent would mean that a person would be able to spend in a given time period $75 in retirement for each $100 spent before retirement. The illustrative replacement rates are projected for a hypothetical single male who works for 37 years and retires in 2047. It is assumed that they use their superannuation guarantee benefit to purchase a lifetime annuity at retirement. The spending power used to calculate the illustrative replacement rates are deflated by the consumer price index to 2008–09 dollars. Actual outcomes will vary depending on factors such as workforce participation, labour income patterns, investment performance, inflation, longevity and whether a person accesses their superannuation prior to Age Pension age.

Note: AWOTE is around $1,200 per week ($62,400 per year). Around half of workers earn less than three-quarters of AWOTE.

Source: Treasury projections.

Findings

Removing the contributions tax and halving the tax on earnings would provide an opportunity to generate more retirement income from the superannuation guarantee system.

The preferential tax treatment of superannuation compared to other savings should be retained. Halving the tax on earnings would be particularly effective in increasing the returns from voluntary superannuation saving.

Effect of recommendations on overall saving

The superannuation system is a significant contributor to Australia's pool of private savings. However, the system's overall effect on national savings depends on the effect on the government's fiscal position (that is, public savings). Superannuation affects public savings by reducing future Age Pension outlays, but the cost of concessions reduces government revenue thereby decreasing public savings.

Empirical studies on the effect of taxes on household saving are constrained due to data limitations and estimation problems. Some progress has been made with respect to studies of tax policies on investment retirement accounts and 401(k) plans in the United States, but the results of such studies are often conflicting (OECD 2007a). Typically, these suggest that taxation is unlikely to have a large impact on total saving, but some studies of the same data find that providing tax incentives leads to substantial amounts of new saving.

There is considerable evidence that tax differences have large effects on which assets a household's savings are invested in. Based on an examination of the literature and its own data, the OECD concluded that low-income individuals are more likely to respond to tax incentives with new saving, but high-income individuals in particular, are more likely to divert savings from taxable to tax-preferred savings (OECD 2007a).

There is also evidence that saving schemes involving commitment or compulsion tend to increase the level of saving. Research has estimated that an extra dollar of superannuation guarantee in Australia has added between 70 and 90 cents to household wealth (Connolly 2007). It is therefore argued that increasing the superannuation guarantee rate would not only increase retirement incomes but would also have national saving benefits.

The recommended changes in this report to the taxation of superannuation would also increase retirement incomes and have national saving benefits.

The recommended changes to the taxation of superannuation would increase private savings more than would an increase in the superannuation guarantee rate to 12 per cent under the current tax arrangements. These benefits would result mainly from halving the earnings tax to 7.5 per cent, which would significantly increase superannuation assets and increase private savings. Superannuation assets are estimated to increase by approximately $590 billion (nominal dollars) by 2029 under the taxation proposals, compared to approximately $370 billion (nominal dollars) if the superannuation guarantee were to be increased to 12 per cent (see Chart A2–9).

Chart A2–9: Projected increase in superannuation assets

Source: Treasury projections.

Based on the assumptions in Annex A2, both the superannuation tax recommendations and increasing the superannuation guarantee rate would increase national saving, but reduce public saving since only part of the revenue forgone in tax concessions for superannuation would be offset by a reduction in pension outlays. The recommended changes would have a greater negative effect on public saving than an increase in the superannuation guarantee to 12 per cent under the current tax arrangements. However, the transfer to private savings resulting from the recommended changes means they would have a greater positive effect on national savings than an increase to the superannuation guarantee rate to 12 per cent (see Chart A2–10).

Chart A2–10: Projected increase in national saving

Source: Treasury projections.

Findings

Superannuation is a significant contributor to Australia's savings pool.

Both the recommended changes to superannuation tax and increasing the superannuation guarantee would increase retirement incomes and national saving. The recommended changes to superannuation tax would provide a greater benefit to national savings than an increase in the superannuation guarantee rate to 12 per cent.

Other tax-related issues

Recommendation 20:

The restriction on people aged 75 and over from making contributions should be removed. However, a work test should still apply for people aged 65 and over. There should be no restrictions on people wanting to purchase longevity insurance products from a prudentially regulated entity.

Submissions to the Review have raised a number of specific tax-related issues, including who can make superannuation contributions, how superannuation is taxed on a person's death and the treatment of benefits paid from an untaxed fund.

Restrictions on superannuation contributions

Superannuation tax concessions have generally been accompanied by restrictions on who can access them. These restrictions take the form of contributions caps, work tests and age limits. They are consistent with the primary purpose of the retirement income system, which is to smooth income over a person's lifetime rather than be a concessional estate planning vehicle.

The work test and age limits apply to people above Age Pension age. From this age, a person must work 40 hours over a 30-day period before they can make a superannuation contribution, while contributions cannot be made from age 75. The current work test is not suitable for establishing eligibility for the proposed tax offset, because its participation demands are minimal and difficult for fund trustees to monitor.

Given the very low rate of tax applied to superannuation fund earnings, compared to other savings, a restriction on people of Age Pension age accessing concessions should continue to apply. This restriction could be in the form of an improved work test or a restriction on the amount of concessions available (a lower contribution cap). However, the restriction on people aged 75 and over, who are currently prevented from making superannuation contributions, should be abolished. If restrictions on accessing concessions continue to exist from Age Pension age, there is no need for further restrictions from the age of 75.

There should be no restrictions on people wanting to purchase longevity insurance from a prudentially regulated entity. This would be an important element in making it easier for people to purchase these products (see Section A2–3).

Death benefits

The tax treatment of superannuation on the death of a person depends on a number of factors, including who inherits the asset. A benefit paid to a dependant, such as a spouse or partner, is tax-free. A benefit paid to a non-dependant is subject to a tax of 15 per cent.13 Some submissions argue that this leads to added complexity and inequities in how benefits are taxed. However, the superannuation tax concessions are provided so a person can finance their retirement, and that of their dependants. On balance, a tax on payments made to non-dependants should continue to apply.

Untaxed funds

People in untaxed superannuation funds, such as some public sector funds, are currently taxed differently from people in the more common taxed superannuation funds. Untaxed funds do not pay tax on some, or all, of the contributions and earnings in the fund. Benefits from these funds remain taxed to achieve a broadly equivalent tax outcome between people in taxed and untaxed funds.

Superannuation pensions paid from an untaxed superannuation fund are taxed at marginal tax rates less a 10 per cent offset. Lump sums from an untaxed fund are taxed at 15 per cent up to a threshold, currently $1.1 million (indexed), and at the top marginal tax rate beyond that.

Several submissions raise concerns that members of untaxed funds pay more tax on their non-superannuation income than members of taxed funds. A pension from a taxed fund is not included in assessable income while a pension from an untaxed fund is. This means that non-superannuation income is added to a pension from an untaxed fund. As a result, the person can pay a higher marginal tax rate on that income than they would have if the pension was paid from a taxed fund.

The considerable differences between taxed and untaxed funds make it very difficult to achieve complete parity between the benefits paid from them. On balance, it is considered that the current tax treatment of benefits paid from an untaxed fund remains appropriate given the recommended changes to the taxation of superannuation contributions and earnings in taxed funds. The treatment of contributions to untaxed funds would need to be carefully considered.

Benefits for people aged less than 60

The taxation of benefits paid to people above their preservation age but under the age of 60 should not change. Taxable lump sums are taxed at 0 per cent up to a threshold (currently $150,000) and 16.5 per cent above that amount. Taxable superannuation pensions are taxed at marginal tax rates less an offset of 15 per cent.

If, as recommended, superannuation contributions are taxed in the hands of the individual, such future contributions would be made on a post-tax basis and would not be subject to further taxation when withdrawn as a superannuation benefit.

12 These amounts include the Pension Supplement pensioners may receive as an additional payment to the base pension. The maximum Pension Supplement is currently $28.05 a week for a single pensioner and $42.30 a week for couples. Rent Assistance is not included in these amounts.

13 The tax is payable on the 'taxable component' of the benefit. This includes contributions and earnings that have been taxed in the fund. Tax is calculated by subtracting the tax-free component from the value of the benefit. The tax-free component is not taxable in the hands of a non-dependant. This includes amounts such as non-concessional contributions that are not taxable in the fund.

The tax on superannuation contributions in the fund should be abolished. Employer superannuation contributions should be treated as income in the hands of the individual, taxed at marginal personal income tax rates and receive a flat-rate refundable tax offset.

An offset should be provided for all superannuation contributions up to an annual cap of $25,000 (indexed). The offset should be set so the majority of taxpayers do not pay more than 15 per cent tax on their contributions. The cap should be doubled for people aged 50 or older.

Recommendation 18(d)

The tax on superannuation contributions in the fund should be abolished. Employer superannuation contributions should be treated as income in the hands of the individual, taxed at marginal personal income tax rates and receive a flat-rate refundable tax offset.

Compulsory superannuation contributions made by employers should not reduce eligibility for income support or family assistance payments. They should also not form part of the calculation for child support.